R&D Tax Credit Overview: PATH Act Adds OpportunitiesR&D Tax Credits Cost Segregation Fixed Asset Review Repair v. Capitalization • State & Local Tax Services Toll-Free 844.787.2121

R&D Tax Credits Cost Segregation Fixed Asset Review Repair v. Capitalization • State & Local Tax Services www.aghsts.com Toll-Free 844.787.2121

R&D Tax Credit Overview: PATH Act Adds Opportunities

Presented by: Bruce L. Stubbs, J.D., LL.M. Vice President AGH Specialized Tax Solutions

R&D Tax Credits Cost Segregation Fixed Asset Reviews Repair v. Capitalization •Sales & Use Tax Services www.aghsts.com • Toll-Free 844.787.2121

Learning Objectives

Impact of Protecting Americans from Tax Hikes (PATH) Act of 2015 Discuss overview of Federal & State benefits Learn how to identify qualified vs. non-qualified activities Differentiate the calculation method options and discuss examples Hear updates on case law, and IRS regulations & proposals

I.

II.

III.

IV.

V.


I. Protecting Americans from

Tax Hikes (PATH) Act of 2015


PATH Act of 2015

• PERMANENT

• Retroactive to amounts paid or incurred after 12/31/2014

• Both calculation methods retained

• No changes to credit percentage rates

• 2 additional options for some to utilize the credit:– Offset against AMT– Offset against payroll tax


PATH Act of 2015

Ability to offset Alternative Minimum Tax (AMT) allowed

Applies to:

• Tax years beginning after Dec. 31, 2015

Limited to:

• “Eligible small businesses” (ESB) – defined as:i. Corporation - the stock of which is not publically traded,ii. Partnership, oriii. Sole proprietorship, andiv. Prior 3-year avg. annual gross receipts do not exceed $50 million


PATH Act of 2015

Ability to utilize the credit to offset payroll taxes

Applies to:

• Startup companies• Tax years beginning after Dec. 31, 2015

Limited to:

• “Qualified small businesses” (QSB) – defined as:i. Corporation, partnership, or individual,ii. Gross receipts < $5 million for the taxable year, andiii. No gross receipts for any tax year preceding the 5-tax-year

period ending with the current tax year


PATH Act of 2015

Payroll tax credit amount is equal to the least of:

1) Amount specified by the taxpayer < $250,000,

2) Research credit determined for the tax year, or

3) If a QSB other than a partnership or S corp., the amount of thebusiness credit carryforward under §39 from the tax year.


PATH Act of 2015

Payroll tax credit limitations:

1. Can’t make election if made for 5 or more preceding tax years

2. Partnership or S Corp - election made at entity level

3. Payroll tax credit portion allowed against employer OASDI (socialsecurity portion) of FICA in 1st quarter after date on whichcompany files its income tax or information return.

4. Can’t exceed OASDI each quarter, carryforward to next quarter.

5. Can’t be taken against hospital insurance liability (HI) of FICA taxes.

6. Can’t be taken against the employee OASDI liability required to bewithheld.


2017 Fiscal Year Budget Proposals

7 R&D Credit proposals: 1. Repeal “old & cold” Regular Credit method

2. Increase ASC rate from 14% to 18%

3. Eliminate the reduced 6% ASC rate for businesses without any QREs in the 3 prior years.

4. All taxpayers could use to offset AMT

5. Contract research expenses would include 75% of payments made to qualified nonprofit organizations (e.g., educational institutions).

6. Pass-through owners would not be limited on usage of credit to tax amount attributable to such trade or business.

7. Repeal 10-year amortization requirement for non-active individuals when calculating individual AMT.


II. Federal & State Benefit Overview


Federal Credit Benefit

• Benefit averages $0.065 per dollar spent on Qualified Research Expenses (QREs).

• IRC §38 - General business credit

• IRC §39 - 1-year carryback, 20-year carryforward

• Dollar-for-dollar reduction in tax Subject to AMT limitations o Eligible small business (ESB) exception


States Offering R&D Credits

• Arizona • Indiana • Nebraska • Texas

• Arkansas • Iowa • New Hampshire • Utah

• California • Kansas • New Jersey • Vermont

• Colorado • Kentucky • New York • Virginia

• Connecticut • Louisiana • North Carolina • West Virginia

• Delaware • Maine • North Dakota • Wisconsin

• Florida • Maryland • Ohio

• Georgia • Massachusetts • Oregon

• Hawaii • Michigan • Pennsylvania

• Idaho • Minnesota • Rhode Island

• Illinois • Mississippi • South Carolina


States Without R&D Credits

• Alabama* • Oklahoma*

• Alaska • South Dakota

• Missouri • Tennessee

• Montana • Washington

• Nevada • Washington DC

• New Mexico • Wyoming


State Credit Benefits

• Nonrefundable vs. refundable

• Application process

• Nontransferable

• Options on utilization


POLLING QUESTION #1


III. Credit Qualifications - Facts vs. Myths


Myths as to Credit Qualification

• Must “discover” something beyond what’s known in the industry False – “Discovery Test” is no longer the standard.

• Only performing “white lab coat” type activities in a high-tech or bio-tech company qualifies. False – Anyone who satisfies the 4-Part Test can qualify.

• Must be successful and product must be available for sale False – Neither are required to qualify for the credit.

• Government contractors don’t qualify. False – Anyone who satisfies the 4-Part Test can potentially qualify

o Need to be “at risk” and “retain rights” o Contract terms are key


Applicable Industries

Applies to all industries, including:

‣ Aircraft ‣ Agriculture ‣ Apparel ‣ Automotive ‣ Chemical ‣ Computer software ‣ Cosmetics ‣ Defense contractors ‣ Electronics

‣ Engineering ‣ Equipment & machinery ‣ Food & beverage ‣ Manufacturing ‣ Medical ‣ Oil & gas ‣ Pharmaceutical ‣ Telecommunications ‣ Tooling, molds & dies


Study Examples

• Packaging films – 3D and holographic

• Bee Shotgun – Developed a ‘gun’ to launch a shell filled with non-lethal smoke to disperse bees on power poles

• Pet products – Puppy pads, soaps, odor removers (chemical formulas)

• Formulas – Food & beverage service providers, flavor formulations, new & replacement ingredient selection, organic and natural foods

• Electric fans – Residential and industrial - motors, blade & case designs

• Defense contractor – Switch components & wiring harnesses for weapons

• Original equipment manufacturers (OEMs): Cable assemblies & throttle controls – Motorcycles and riding lawn

mowers Plastic tubing – Medical devices & equipment


IV. R&D 4-Part Test and

Qualified Activities & Expenses


R&D 4-Part Test

• Must be present at beginning of project • Uncertainty concerns: capability, methodology, or

appropriateness of design

Test # 1 Elimination of Uncertainty

• Physical or biological sciences, computer science or engineering

Test # 2 Technological in Nature

• New or improved business component as to: function, performance, reliability or quality

• Not qualified if relates to: style, taste, cosmetic or seasonal design factors

Test # 3 Permitted Purpose

• Evaluate 1 or more alternatives to resolve uncertainty. • Substantially all activities (> 80%) constitute elements of a

process of experimentation.

Test # 4 Process of

Experimentation


Internal Use Software

• The software must be technologically innovative in a unique or novel way from prior implementations or methods (substantial improvements in speed or capabilities).

Test # 5 Innovation

• Substantial resources committed to project, and uncertainty such funds will be recovered in a reasonable period of time because of technical uncertainties.

Test # 6 Significant Economic

Risk

• Software that satisfies taxpayer’s requirements without substantial modification is not available for purchase, lease or license.

Test # 7 Not Commercially

Available

3 Additional Tests (“high threshold of innovation”):


Qualified Activities

Idea Generation

Product Design

Prototype Build & Testing

Final Approval

Idea Generation:

• Concept design

• Technical / performance specifications identified

• Technical team meetings

Prototype Design:

• 3D modeling

• Technical design meetings

• Production capability assessment

• New tooling design & development

Prototypes:

• CAD analysis

• Product mock-up

• Destructive or non-destructive testing

• QA testing

• Life cycle testing

• Field testing

Final Approvals:

• Design

• Performance specs

• Safety review

• Certifications

R&D Timeline


Non-Qualified Activities

Per §41(d)(4): • Activities performed outside the United States, Commonwealth of

Puerto Rico, or any US possession • Adaptation or duplication of an existing business component • Social sciences – “Soft” sciences, arts, or humanities • Surveys or studies related to efficiencies; management function,

technique or profitability; market research, testing or development (including advertising & promotions); style, taste, cosmetic or seasonal design factors

• Routine data collection and ordinary QA testing • Funded research – Anything funded by any grant, contract or

otherwise by any person or governmental entity Taxpayer must bear both the economic risk & retain rights in the

results.


Non-Qualified Activities

Per §41(d)(4)(A): Research after commercial production

Per Reg. §1.41-4(c)(2)(ii) - the following are deemed to occur after commercial production:

• Preproduction planning for a finished business component • Tooling up for production • Trial production runs • Troubleshooting detecting faults in production equipment

or processes • Accumulating data relating to production processes • Debugging flaws in a business component


Qualified Research Expenses IRC §174 – Research & Experimental

Expenditures “…incurred in connection with the

taxpayer’s trade or business…”

“in the experimental or laboratory sense”

to eliminate uncertainty concerning new or

improved products or processes

IRC §41 R&D credit limits qualified expenses to 3 buckets:

Wages Supplies Contract Research

§174 expenditures: • Salaries • Utilities • Drawings • Models • Attorney’s fees • Patent fees • Depreciation on R&D

equipment & facilities


Qualified Research Expenses

1. W-2, Box 1 income - as defined under §3401 subject to withholding (includes taxable benefits, bonuses, etc.) Excludes: 401k & pre-tax benefits; and wages used for Work Opportunity Credit 2) Partnership earnings subject

to SE tax 3) Schedule C income

(Self-employed individuals)

Wages

Tangible property used or consumed in qualified research activities (e.g., prototypes) Excludes: a) Land – acquisition &

improvements b) Depreciable property

Supplies Contract Research

1) 65% of amounts paid to non-employees

2) 75% paid to certain qualified research consortia

3) 100% of amounts paid for energy research to eligible small businesses, universities, and Federal laboratories


POLLING QUESTION #2


V. Calculation Methods & Examples


2 Annual Considerations

Two key considerations each year: 1. Which credit method to use 2. Whether to make the §280C Reduced Credit Election

§280C Reduced Credit Election:

• Annual election • 35% reduction to current year’s calculated credit amount • Avoids reduction to current year QREs deducted by amount of the

credit • No “double benefit” • Generally will make the §280C election if subject to tax • Preserves election if taxpayer amends return to claim R&D credit


Calculation Methods

Two calculation methods currently available:

1. Regular Credit - §41(a)(1) • “Old & Cold” method • Base Period (1984 – 1988) or Start-up (1994 – forward)

2. Alternative Simplified Credit (ASC) - §41(c)(5) • Available for tax years ending after Dec. 31, 2006 • Fewer years involved - current year & prior 3 years


Regular Credit Method

• IRC §41(a)(1)

• Credit = 20% x Current Year QREs over Base Amount

• 4 items necessary to calculate the Regular Credit: Step 1 - Qualified Research Expenses (QREs) Step 2 - Prior 4 Years Average Annual Gross Receipts Step 3 - Fixed-Base % Step 4 - Base Amount


Step 2 – Prior 4 Years Avg. Gross Receipts

• Reg. §1.41-3(c): Gross Receipts is a broad definition & includes “… the total amount … derived by the taxpayer from all its activities…” including:

⁃ Net sales ⁃ Rental income ⁃ Interest income ⁃ Royalty income ⁃ Dividend income ⁃ Other income

• Six exclusions – Reg. §1.41-3(c)(2)(i) – (vi): Returns or allowances Receipts from the sale or exchange of capital assets (§1221) Repayment of loans or similar instruments Receipts from sale or exchange not in the ordinary course of

business Amounts received as sales & other taxes merely collected & remitted De minimis rule of active gross receipts less than $25,000


Step 3 - Fixed-Base %

Method depends on when the company was organized & 1st performed R&D

Either: (1) Base Period Fixed-Base % If have both Qualified Research Expenses & Gross Receipts prior to 1984 and in 3 out of 5 years during 1984 – 1988, then: Fixed-Base % = 1984-1988 QREs / 1984-1988 GRs

(2) Start-up Fixed-Base % If 1st taxable year beginning after Dec. 31, 1993, when taxpayer has both Qualified Research Expenses & Gross Receipts, then: Fixed-Base % is:

• 3% fixed for 1st 5 tax years • Fluctuates over next 5 tax years based on formulas • Becomes fixed in year 11 – unless acquisitions or dispositions occur

Maximum Fixed-Base % = 16%


Step 4 - Base Amount

• Base Amount limits the amount of Qualified Research Expenses available for the current year credit calculation.

• Regular Credit Base Amount is always the greater of: Fixed-Base % x 4 Prior Year Average Annual Gross Receipts; or

50% of Current Year QREs (Minimum Base Amount)

• Regular Credit calculation favors taxpayers with: Increasing QREs Low Fixed-Base % Flat or decreasing sales


Regular Credit – Example

Assume 1984 – 1988 Base Period applies as follows:

• Step 1 - Current Year QREs $1,350,000

• Step 2 - Prior 4 Yr. Avg. Annual Gross Receipts 2011 – 2014 = $130,000,000 / 4 = $32,500,000

• Step 3 - Fixed-Base % 1984 – 1988 QREs Total = $1,200,000 1984 – 1988 Gross Receipts Total = $45,000,000 Fixed-Base % = 2.67%


Regular Credit - Example

1. Current Year QREs

2. 4 Prior Yr. Avg. Gross Receipts

3. Fixed-Base %

(A) Tentative Base Amount (2 x 3)

(B) Minimum Base Amount (50% of CY QREs)

4. Base Amount (Greater of A or B)

QREs available for credit

Credit %

Regular Credit Amount

§280C Reduced Credit Election

Net Credit Amount

Net Effective Reduced Credit Rate

Example #1 Example #2 Example #3

1,350,000 1,350,000 1,350,000

32,500,000 32,500,000 32,500,000

2.67% 1.67% 4.16%

867,750 542,750 1,352,000

675,000 675,000 675,000

867,750 675,000 1,352,000

482,250 675,000 0

20% 20%

96,450 135,000

65% 65%

62,693 87,750

4.64% 6.50%


Alternative Simplified Credit (ASC)

• IRC §41(c)(5)

• Available for tax years ending after Dec. 31, 2006

• ASC Credit = 14% x QREs over Base Amount

• Base Amount = 50% x average QREs for prior 3 years

• Only factor included in calculation is qualified R&D expenses NOTE: Gross Receipts & Fixed-Base % are not a factor.

• Caveat: If no QREs in any 1 of the 3 preceding tax years, then: ASC Credit = 6% x Current Year QREs


Alternative Simplified Credit (ASC)

• Benefit % depends on the increase or decrease of the Current Year QREs over the prior 3 years’ QREs.

• ASC Method is an annual election. Must be made on a timely filed original return (including extensions) if

changing from Regular Credit to ASC Automatic consent deemed provided to change from ASC Method to Regular

Method, or vice versa, if made on timely filed original return (including extensions)

2015 RULE CHANGE: o Now can use ASC on amended returns o Not available on amended returns if a credit was claimed in prior year

using a method other than the ASC

• Benefits taxpayers with increasing QREs, flat QREs, small fluctuations in QREs, or slightly decreasing QREs


ASC – Increasing Spend

PY QREs: 2011 = $ 500,000 2012 = $ 650,000 2013 = $ 950,000 Total = $2,100,000 ÷ 3 3 Yr Avg. = $ 700,000 Less: 50% CY Base Amount = $ 350,000

Current Year QREs = $1,350,000 Less: CY Base Amt = ($ 350,000) CY QREs Available = $ 1,000,000 ASC Credit % = 14% ASC Credit = $ 140,000

§280C Reduced Credit (Election) 65%

ASC Reduced Credit = $ 91,000 Net Effective Reduced Credit Rate = 6.74%


ASC – Decreasing Spend

PY QREs: 2011 = $ 900,000 2012 = $ 750,000 2013 = $ 600,000 Total = $2,250,000 ÷ 3 3 Yr Avg. = $ 750,000 Less: 50% CY Base Amount = $ 375,000

Current Year QREs = $ 475,000 Less: CY Base Amt = ($375,000) CY QREs Available = $ 100,000 ASC Credit % = 14% ASC Credit = $ 14,000 §280C Reduced Credit 65% (Election)

ASC Reduced Credit = $ 9,100 Net Effective Reduced Credit Rate = 1.92%


Case Study #1

NewCo’s 1st year in operation is 2015. Which method produces best result?

Regular Method ASC Method

Current Year QREs $780,000 Current Year QREs $780,000

4 Prior Yr. Avg. GR’s $ - 0 -

F-B% (Fixed) 3%

Base Amount Limitation (50%) $390,000

QREs Available for Credit $390,000

Credit % 20% Credit % 6%

Regular Credit Amount $78,000 ASC Credit Amount $46,800

§280C Reduced Credit 65% §280C Reduced Credit 65%

Net Credit Amount $50,700 Net Credit Amount $30,420


Case Study #2

Taxpayer organized in 1986. Performing R&D since inception. Never claimed the credit. Did not want to establish the F-B%.

Year Total QREs Federal Credit* California Credit* 2013 $981,560 $60,496 $71,985 2012 $685,600 2011 $774,700 2010 $440,200 $132,481

* Credit amounts reflect §280C reduced credit election


Additional Considerations • Consistency rule Must apply the same definition used for QREs & Gross Receipts in the

Credit Year in computing the fixed-base % and base amount

• Acquisitions & Dispositions Requires calculation adjustments

• Documentation 4-Part Test – uncertainties, process of experimentation Track at business component level Nexus for tracking costs Time tracking system Sufficient software capability to capture necessary information


Preserve §280C Reduced Credit Election

Check yes on line 17 √


POLLING QUESTION #3


VI. IRS Updates and Case Law


IRS Updates

Internal Use Software (IUS)

Jan. 16, 2015 – Prop. Reg. (REG-153653-03) released

1. Distinguishes IUS from non-IUS

2. IUS is ‘general and administrative functions’ – limited to: a. Financial management functions b. Human resource management functions c. Support services functions (day-to-day type activities)

3. Non-IUS a. Held for commercial sale, lease, or license; or b. Third-party-facing - interacts with 3rd parties, or allows 3rd parties

to initiate functions or review data on taxpayer’s system


IRS Updates


4. High threshold of innovation tests still apply to IUS a. Prong 1 – Innovation

i. Reduction in cost or improvement of speed or other measurable improvement that is substantial and economically significant

b. Prong 2 – Significant economic risk i. Application at the level of ‘substantial uncertainty’ present at the

beginning, not the degree of innovation achieved ii. ‘Substantial uncertainty’ exists if available information doesn’t

establish the ‘capability or method’, not to the appropriate design iii. Both technical and economic risk must be present

c. Prong 3 – Not commercially available for use without modification – which satisfies Prongs 1 and 2


IRS Updates


5. Dual-function software – both internal and non-internal use a) Rules presume – designed “primarily” for internal use

b) No presumption if a subset is identified & only serves as third-party-functional interaction (TPFI) – only 4-Part Test applies

c) Safe harbor available if unable to isolate one or more subsets

1. If reasonably anticipated at least 10% will constitute TPFI, then 25% of QREs must only pass 4-Part Test, remaining 75% must pass “high threshold of innovation” test

2. 4 examples provided on dual-function software

6. Process of Experimentation (POE) examples for software provided


IRS Regulation Updates

1. Alternative Simplified Credit (ASC) Allowed on Amended Returns

Final regulations issued on 2/26/2015 (T.D. 9712)

2 limitations: • Not allowed if claimed a credit using a different method in prior year(s)

• Members of controlled group may not use if any member had claimed a credit for that year and used a method other than ASC

2. Allocation of Controlled Group Credit

Final & temp. regulations issued 4/3/2015 (T.D. 9717)

Group credit is allocated based on each member’s proportionate share of aggregate QREs.

Eliminates convoluted allocation process based on each member’s stand-alone credit compared to the group credit.


IRS Updates

3. Gross Receipts from Transactions Between Group Members

Prop. Reg. §1.41-6 published Dec. 13, 2013

General rule: Intra-group transactions are disregarded.

Exception under Prop. Reg. §1.41-6 - Gross Receipts included if:

• A foreign corporate controlled group member engages in a transaction with a non-member (external transaction) involving the same or a modified version of tangible or intangible property or a service that was the subject of 1 or more intra-group transactions; and

• The external transaction does not give rise to gross receipts that are effectively connected with a trade or business within the U.S., the Commonwealth of Puerto Rico, or any U.S. possession.


Case Law

Geosyntec Consultants, Inc. v. U.S., 115 AFTR 2d 2015-644, 776 F3d 1330, 2015-1 USTC ¶50,170 (CA11, 1/29/2015)

Issue: Whether contracts were considered “funded research”?

2 types of contracts involved: I. Fixed-price contracts (aka lump sum contracts) II. Cost-plus subject to a maximum (“capped contracts”)

Court held: I. Fixed-price contracts ≠ Funded research – eligible for credit II. Cost-plus contracts = Funded research – not eligible for credit


POLLING QUESTION #4


QUESTIONS


Contact Information

AGH STS SERVICES • R&D Tax Credits • Cost Segregation • 45L Energy Efficient Tax

Credits • Repair & Maintenance

Studies • Fixed Asset Reviews • State & Local Tax Services • Property Tax • Expense Recovery • IC-DISC

Bruce L. Stubbs, J.D., LL.M. Vice President AGH Specialized Tax Solutions, LLC 844.787.2121 [email protected]

mailto:[email protected]


Disclaimer NOTE: Any advice contained in this material is not intended or written to be tax advice, and cannot be relied upon as such, nor can it be used for the purpose of avoiding tax penalties that may be imposed by the IRS or states, or promoting, marketing or recommending to another party any transaction or matter addressed herein. The foregoing slides and any materials accompanying them are for educational purposes prepared by AGH Specialized Tax Solutions, LLC and are not intended as advice directed at any particular party or to a client-specific fact pattern. The information contained in this presentation provides background information about certain legal and accounting issues and should not be regarded as rendering legal or accounting advice to any person or entity. As such, the information is not privileged and does not create an attorney-client relationship or accountant-client relationship with you. You should not act, or refrain from acting, based upon any information so provided. In addition, the information contained in this presentation is not specific to any particular case or situation and may not reflect the most current legal developments, verdicts, or settlements. You may contact us or an independent tax advisor to discuss the potential application of these issues to your particular situation. In the event that you have questions about and want to seek legal or professional advice concerning your particular situation in light of the matters discussed in this presentation, please contact us so that we can discuss the necessary steps to form a professional-client relationship if it is warranted. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. © 2016 AGH Specialized Tax Solutions, LLC. All rights reserved. This material is the work of AGH Specialized Tax Solutions, LLC.

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R&D Tax Credit Overview: PATH Act Adds OpportunitiesR&D Tax Credits Cost Segregation Fixed Asset Review Repair v. Capitalization • State & Local Tax Services Toll-Free 844.787.2121